Eliminate the state tax deduction

Eliminate the state tax deduction

June 19, 2016

By Jan Moller

With only a few days left before its June 23 adjournment, Louisiana’s Legislature seems unlikely to raise all the revenue needed to avoid deep cuts to education, healthcare and other critical services. But there is still time to pass a much-needed reform to our income tax system by repealing the ability to deduct state income taxes on state tax returns.

Louisiana is one of only four states that currently allow this deduction in full. Analysts from across the political spectrum agree that it is outdated and ineffective. Eliminating this tax break would raise as much as $101 million for next year’s budget, and restore some much-needed fairness to a tax system that doesn’t raise enough money to support critical needs and is riddled with favoritism toward the wealthiest taxpayers.

Background: The original version of House Bill 38 proposed to reduce the amount of federal itemized deductions that Louisiana taxpayers could claim on their state returns. Currently they can claim 100 percent of such deductions, but the bill would have lowered that to 57.5 percent. The Legislative Fiscal Office estimates that the change would have generated $117 million in revenue for the state budget. More than three-fourths of the revenue would come from households with incomes over $103,000 per year.

But amendments added to HB 38 in the Ways & Means Committee made it a much weaker bill. The amendments put a two-year sunset on the bill, and impose a payback mechanism that would provide a refund to those who paid the extra tax if the state’s revenue forecast improves over the next two years. In other words: If Louisiana’s economy fares better than expected, the additional tax revenues generated by this growth must be given to the wealthiest households in the state instead of being used for healthcare, education and other state priorities.

A better solution: There is a better way forward. An amendment proposed by the bill’s author would maintain the current 100 percent deductibility of federal excess itemized deductions. But it would eliminate the ability to deduct state income taxes – putting Louisiana in line with every state except Arizona, Georgia and North Dakota.

Several states have eliminated this deduction in recent years – New Mexico and Rhode Island in 2010, Vermont in 2015 and Oklahoma earlier this year. Even in states where it remains, leading economists note that the deduction “does not appear to have economic justification.”

Currently in Louisiana, 90 percent of the revenue from this deduction flows to the wealthiest 20 percent of tax filers. Fully two-thirds of the benefits go to the richest 5 percent.

Carl Davis, research director for the Institute on Taxation and Economic Policy (ITEP), recently explained why the state deduction doesn’t make economic sense:

The federal deduction for state income taxes paid exists primarily as a way for the federal government to aid state governments. In effect, by letting taxpayers write off their state income tax payments, the federal government is indirectly providing states with a portion of the income tax revenue they collect. Since a state obviously cannot provide aid to itself, however, this rationale is thrown out the window at the state level.

Conclusion: There is an understandable desire among legislators to make sure that any revenue increases are part of a broader effort to reform Louisiana’s tax code. With the amendment offered to House Bill 38, they can do both. The money generated by this change won’t be enough to fully fund TOPS, plug holes in the healthcare safety net or provide teachers with the pay raise they deserve. But it is a much-needed reform that eliminates an absurd feature of our current tax code.

In a session where the focus, justifiably, has been on ways to fill a massive hole in the state budget, the amendments proposed for House Bill 38 also represents a solid down payment on the structural tax reforms that should be the state’s primary focus in 2017.

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The Louisiana Budget Project (LBP) monitors and reports on public policy and how it affects Louisiana’s low- to moderate-income families.